Why experts are worried about Tether, a dollar-pegged cryptocurrency

Markets treat a tether as though it's worth $1. But what if it's not?

Tethers have ballooned over the last nine months

On April 13, just days after it announced it was paying off its IOUs, Bitfinex admitted that it was "experiencing delays in the processing of outbound USD wires to customers." Bitfinex—and Tether—have struggled to gain access to the conventional financial system ever since.

"Since April 18, 2017, all incoming international wires to Tether have been blocked and refused by our Taiwanese banks," Tether's website says. "As such, we do not expect the supply of tethers to increase substantially until these constraints have been lifted."

That notice was posted to Tether's website last year, and it still has a prominent link from Tether's home page. But in reality, the supply of tethers has increased substantially. On April 18, 2017, the supply of tethers was a little more than $50 million. Since then, the figure has grown to $2.2 billion—with $850 million being created since the start of 2018.

An obvious question here is how customers have been sending dollars to Tether to trade in for all those tethers if Tether isn't able to accept international wire transfers. Tether hasn't provided a clear explanation, and some critics have suggested that Tether might simply be creating new tethers without having anything backing them up.

Tether could put these concerns to rest by sharing one of those "frequent professional audits" that Tether promises on its website. But so far, the documents Tether has released in recent months have raised more questions than answers.

Last year, Tether released a document showing that on March 31, the company had $44 million in the bank. This figure matched the outstanding tethers at the time. So far so good.

But the next document was released in September, and It differed from the March document in some alarming ways. Written by the Friedman accounting firm, it said this at the beginning: "This information is intended solely to assist the management of Tether Limited, and solely for management's use, and is not intended to be, and should not be, used or relied on by any other party."

The memo goes on to say that Friedman had verified there was a total of $443 million deposited in two bank accounts—matching the $443 million in tethers that were outstanding at the time. But it included a couple of huge asterisks.

First, $60 million of the money wasn't actually in Tether's name. It was in the name of an individual connected to Tether. Supposedly, a trust agreement gives Tether the right to this money, but Friedman "makes no representations about the sufficiency or enforceability of any trust agreement."

More importantly, the accountants said that they "did not evaluate the terms of the above bank accounts and makes no representations about the Client's ability to access funds from the accounts or whether the funds are committed for purposes other than Tether token redemptions." This means, for example, that if Bitfinex had temporarily loaned money to Tether to help it pass the review, Friedman wouldn't necessarily have uncovered this fact.

Tether's March statement named seven banks that were holding Tether funds, most of which were based in Taiwan. In the September memo, only two bank accounts were listed—one for Tether, and one for the unnamed individual. The names of the banks were redacted.

In an email to Ars, a Tether spokesman declined to comment on why it was keeping this information secret. But one possible theory is that the company may be afraid that it would lose its last remaining bank accounts if the name of the bank becomes publicly known. Something caused US banks to blacklist Bitfinex and Tether early last year—those same factors may have put pressure on Taiwanese banks to drop Bitfinex and Tether as customers.

So it's possible Tether is keeping the identity of its bank secret to avoid attracting scrutiny from local regulators. This could also explain why some of Tether's funds are being held in the personal account of a Tether associate—perhaps the bank would have refused to open the account if it had known it was really for Tether.

The bottom line is that Tether isn't living up to its own promises for transparency and "frequent professional audits." Tether's books are apparently such a mess that the professional accounting firm it retained eight months ago has dropped Tether as a client.

Tether's failure could trigger a broader crisis

While there's a lot of circumstantial evidence suggesting that something odd is going on with Bitfinex and Tether, we don't have any hard evidence that these companies are insolvent. And we should hope the critics are wrong, because the stakes here could be quite high.

A big reason tether has become popular is that there is a significant amount of friction when people trade conventional currencies for cryptocurrencies. Companies that enable trading of cryptocurrencies for conventional cash are required to comply with anti-money-laundering laws—including verifying the identity of customers. Banks have been reluctant to work with cryptocurrency exchanges due to the risk of both fraud and regulatory complications, and it has taken years for the most reputable exchanges to develop stable relationships with their banking partners.

These frictions largely don't exist for exchanges that focus on trading between different cryptocurrencies. You don't need permission from banks or regulators to build a trading service based on blockchains, so the barrier to entry for building a cryptocurrency-only exchange is much lower. And a fair number of customers value this kind of exchange, including those who are unwilling or unable to comply with the "know your customer" procedures that mainstream exchanges must enforce.

So a dollar-pegged cryptocurrency like tether can provide a shortcut for someone trying to offer cryptocurrency exchange services outside of the conventional financial system. On an exchange that supports tether, customers can trade bitcoins against tether "dollars" without the hassles that come from interfacing with the conventional banking system. Today, more than a dozen cryptocurrency exchanges have done just that—offering the ability to trade between bitcoin and tether.

Because a dollar-pegged cryptocurrency like tether is so useful, demand is likely to outstrip supply as long as the cryptocurrency economy is expanding. And that means that if—hypothetically—a company like Tether were to issue tokens that aren't actually backed by anything, it's unlikely anyone would notice in the midst of a cryptocurrency boom like what we saw for most of last year.

But problems could start to crop up during a downturn—in a situation where a company might start to see more people wanting to sell tokens for cash than vice versa. Such a company would have to dip into its financial reserves, and if those reserves started to run out it could create turmoil in cryptocurrency markets. People who thought they were holding dollars would suddenly discover they were wrong. It's hard to predict what would happen next, but it's safe to say it wouldn't be pretty.